• Where are we in the investment cycle?
• How are other investors positioned? i.e. is there concentration risk?.

For us the investment cycle is dominated by liquidity. Therefore, to understand our current position, we plot movements in the Global Liquidity Index (GLI). See:
www.liquidity.com This index tracks net liquidity (cash plus credit) injections into world financial markets by policy-makers and credit-providers. It has been regularly published on a monthly basis since the mid-1980s, using data gathered from some 80 economies Worldwide.

We think of the liquidity cycle as having a span of around 9-10 years and often moving in an 'M' shape that starts out of the turmoil of a banking crisis and ends with a commodity price blow-off. More liquidity tends to steepen yield curves, reduce default risks and boost risk asset prices. Thus, the cycle is often seen in binary terms as either 'Risk On' or 'Risk Off'. However, there are in reality four distinct phases, each described by different combinations of credit risk and market risk. We dub these four phases, respectively:
Calm, Speculation, Turbulence and Rebound. Different asset types perform differently according to the phase of the investment cycle that we are in.

High credit risk tends to be associated with periods of falling liquidity, when it becomes increasingly hard to get finance or re-finance. These are the
Speculation and Turbulence phases. During these times, we should expect to see interest rate yield curves flatten and credit spreads widen. Typically, investors should lower asset duration when in these two phases.

High market risk is associated with times of low liquidity, when selling existing asset positions proves difficult. These times are described by the
Turbulence and Rebound market phases. Paralleling high market risk, we should also expect to see more concentrated investor portfolios with little cash and high levels of prevailing price volatility, measured, say, by the VIX. Investors should attempt to lower beta during these phases.

Calm correspondingly represents a phase of generally low market risk and low credit risk. This is when investors should take on both more duration and more beta. Equities and, particularly, so- called cyclical growth equities, e.g. financials, technology and retail, all tend to perform strongly in this phase.

Speculation, the next investment phase, experiences more difficulty in borrowing, largely because of greater competition from industry and large-scale real capital projects, and rising duration risk. Times when the liquidity cycle is above average usually coincide with periods of accelerating economic activity; periods of decelerating liquidity tend to align with periods of above trend economic activity. Therefore, the
Speculation phase denotes a mid-point of the business cycle and is associated with strong commodity markets and outperformance from so- called cyclical value shares, e.g. manufacturing, autos, mining and oil. It is a period when high beta should be maintained and this phase often sees bond markets selling off.

Turbulence, a phase of high credit risk and high market risk follows. This phase is not always associated with poor portfolio performance. Yet risks are at their highest in
Turbulence. Consequently our investment stance is to favour cash, short dated government debt and defensive value equity sectors, such as utilities. Following on is the
Rebound phase of the cycle. This phase enjoys falling duration risk but it is often the time of bleakest economic news. Market risk consequently remains high. Long dated government debt and defensive growth industry groups, e.g. foods and drugs, are our favoured investments here.

Returning to the archetypical M-shaped cycle, most banking crises tend to occur near the trough of the cycle and between the
Turbulence and Rebound phases. The cycle-ending commodity booms are usually seen in the
Speculation and early Turbulence phases. The midpoint of the M-cycle should see a mild correction and ranging market characterised by comparatively short-lived and shallow
Turbulence and Rebound phases. Tactically, a little more cash and a few more bonds might be held at these times. In summary, the full investment cycle typically sees eight phases: two standard
Calm and Speculation phases, separated by mild Turbulence and Rebound regimes, preceded by a standard Rebound and ending with a standard
Turbulence phase.